What are reserve funds?
HOA reserve funds are like a savings account for major items such as resurfacing asphalt, replacing roofs, etc. The reserve study typically forecasts out the costs of maintaining these various components for the next 30 years. As a financial advisor, I help my clients figure out how much they should budget every month for everyday expenses and whatever savings we can accomplish for the future are placed in investments. Your operating funds are a portion of your dues that pays for the everyday expenses like staff salaries, routine landscaping and utilities whereas your savings should pay for big items and life events like a new car, major house repairs and retirement. As a former director, there was next to zero training on this and I learned a lot of this when some accounting irregularities surfaced. It is important to know the lingo when reading reserve studies and also to speak authoritatively on the subject, otherwise there are those know-it-alls out there that will be quick to correct you. The other thing that directors and finance committee members love to say when they’ve been caught for overspending is “the reserve study is not a budget, it’s just a guideline.”
- Contribution: The amount of your assessment or “dues” that goes toward reserves.
- Allocation: Money set aside in a certain year to be expended for a certain purpose. For example, $500,000 might be “allocated” in the reserve study in the current year for the roof replacement.
- Assessment: This is actually your dues, not to be confused with a “special assessment” which is usually a one-time collection to fund a reserves shortfall.
- Useful Life: The amount of time a component will last or need to be repaired. A roof might be 20 years, but the pool component might budget replastering every eight years but never a full replacement.
Think of it like all of these different payment plans. For a car, your car payment might be for six years whereas your house payment is for 30 years. Top top that off, you are saving for expenses in the future like that new roof. There might be years where your “contribution” to roof reserves might be $30,000 but your allocation, or what you plan to spend that year, is $0. The year you replace your roof, your contribution might be just $30,000 but your allocation, or what you spend, is $500,000. Basically, you are paying for maintaining and replacing over time.
Required by state law
California Civil Code § 5550 requires HOAs to annually review their reserve study and to complete a physical on-site visit every three years. For most HOAs, they provide a contracted reserve analyst the financial information they need annually to update their reserve study from the prior year. In the third year, our reserve analysts makes an on-site physical inspection and is very knowledgeable about the various issues inherent with certain materials. The board provides the reserve analyst a rough estimate of where they think the ending reserve balances will be along with their spending plans. For example, the board may instruct the reserve analyst to delay the clubhouse remodel for five years from what was in the prior year’s reserve study.
What does the “percent funded” mean?
Percent funded is calculated by dividing the current reserve fund balance by the “fully funded balance” which is cash reserves necessary to repair, replace, restore or maintain major components during and at the end of their first remaining useful life. It might be that the reserve study estimates the pool will be replastered in 2030, so this amount will be discounted into today’s present value. If you don’t know how to calculate present and future values, this is a function of the estimated inflation.
First Service writes that there isn’t an “ideal” funding level, but 70% is typically what most reserve specialists suggest. It’s a great article and I recommend it as additional reading. In looking at my HOA’s reserve study by Browning Reserve Group, they define the “percent funded status” as:
- Poor: 0% to 30% funded
- Fair: 30% to 70% funded
- Strong: 70% to 100% funded
One thing I like to do is look at the projected reserve balances which includes the fully funded balance and percent funded over the next 30 years. Here, I look at the overall trends. If there is a huge downward trend, I try to understand it by looking at the allocated projects in those years. For example, you might see a huge dip to in those years where the roofs are being replaced and then the percent funded trend starts to increase. Ebbs and flows are natural, but a downward death spiral can sometimes mean a special assessment is on its way because you have a mathematical ticking time bomb.
Look at the year end financials against the reserve study
Another thing that I like to do is look at how the HOA ended the year in comparison to what the reserve study allocated to be spent toward various components. For example, your 2024 reserve study was published in the fall of 2023 but had been in the works for months. Once you receive the 2023 financials with reserve balances, look to see if this number is higher or lower than what was used in the reserve study. If the reserve balance is higher than what was estimated in the reserve report, is this because they didn’t finish a project or get billed in that year? Also, look at the amount expended in each component item for 2023 to see if this is over what was allocated. Even though it’s a 2024 reserve study, the 2023 component allocations will be included in the In this, they report the “beginning Here, you can see if the board spent more than what was allocated for the various components. Some of this gets kind of technical, so I hope to make a video to show you how this work.
Comparing year end financials to the reserve study is also a good way to check for errors. In doing this, I discovered that the Treasurer and management accidentally gave our reserve analyst the year-to-date numbers of what had been expended in reserves instead what was projected to be spent. In short, this inflated our year end reserve balance to be much higher than where we ended the year. Unfortunately, this plays into how our reserve contribution is calculated and we likely were not contributing enough to reserves. We fortunately had the offset of high interest earnings of reserve funds but my guess is that we will see a large increase in our reserve contribution unless we get lucky and our big paint and siding estimates are lower than what we built into this year’s reserve study. Not sure if you followed all of that, so my apologies.
Reserve spending for fall leaf cleanup? That is just wrong and it happens.
Review reserve expenses in the monthly financials and ask to see invoices to ensure the HOA is not spending reserve funds for what should come from operations. In my opinion, reserve spending is being used to pay for items that should be in operations as in my HOA’s “fall leaf cleanup.” There is a debate about this, but paying for fall leaf cleanup out of reserves is like putting your housecleaning on a credit card and only making the minimum payments. California Civil Code 5510(b) states, “The board shall not expend funds designated as reserve funds for any purpose other than the repair, restoration, replacement, or maintenance of, or litigation involving the repair, restoration, replacement, or maintenance of, major components that the association is obligated to repair, restore, replace, or maintain and for which the reserve fund was established.” Maybe their argument is that a tree is a rightful reserve component, so the dropping of its leaves must be a reserve expense? The problem is that it happens every year. In my opinion, this is a real stretch and should be in operating but this would cause our dues to go up as our contribution for this is less than what we are spending. Unfortunately, there’s not much you can do about this than voice your opinion and call them out for it.
The Reserve Study Is A “Living Document”
As a financial advisor, most of us create “financial plans” for our client which helps them plan into future for kids’ college, retirement, etc. We sometimes meet with our clients annually to see if there have been any changes and if adjustments are needed based on the unpredictability of life, like an unexpected health event forces you into an early retirement. The same is true for your HOA. When I was a director, we unfortunately got a bid for our paint and siding project which was artificially low. Things happen and just like in real life when you delay the new car purchase, adjustments can be in the next year’s reserve study. It will never be perfect but don’t let the directors use the “reserve study is not a budget” as an excuse to overspend in discretionary projects such as landscaping renovations.
Find out how your reserve funds are invested!
This is where you will likely find the problems. Our recent treasurer noticed a sudden $30,000’ish drop in reserve interest one month. He did some digging and discovered that our management company failed to invest the cash as instructed. There might also be funds not receiving a competitive rate. Ask to see where the reserve funds are invested. Make sure that reserve funds are receiving a competitive interest rate by researching CDs and money market rates on the internet.
Unlike saving for retirement that is ten years out in a mix of bonds and stocks, reserve funds are typically only invested in high yield savings and money market accounts, CDs and short-term treasuries. They should not be investing more than $250,000 with one bank due to the FDIC limits unless the bank is able to provide additional insurance or guarantees for their treasury management services. Your HOA cannot take the same kind of risks as we do personally as they have a fiduciary duty to see that the money is there when needed. Reserve funds are often invested in accordance to the reserve study. If there is a major reserve expense in a certain year, make sure that you have money available when that time comes.
The recent high interest rates have been a great offset to the out of control inflation for materials and labor for our big paint and siding project. When I first started as a director, it was when interest rates were low and seeing our higher yielding CDs mature was not fun. Reserve study’s generally forecast interest rates at 2.5%, but they also forecast inflation at 2.5%. We cannot predict the future, so that’s a reasonable guesstimate.
Final words
I will be diving deep into a few of the reserve related items and maybe even do a YouTube video where I can show you an actual reserve study and financials, along with how they work. In doing research for this article, I learned that there is a reserve study consultant that even offers a DIY reserve study for boards at www.diyreservestudy.com.
DISCLOSURE: This article is provided for information purposes only and does not constitute financial or legal advice. The author is not a certified homeowner association professional and speaks only from personal experience and opinions. Advise readers to do their own research and make their own conclusions.
